Whether it’s working with new clients to build out a holistic financial plan or tweaking a current client’s overall strategy, we consistently get questions about employer-sponsored 401(k) investments and how they factor into retirement planning.
While 401(k) investment accounts are common, strategically managing these accounts can get a bit tricky, especially when you are relying on them to achieve your long-term financial goals. Certain misconceptions can lead to missed opportunities, unexpected tax liabilities, or inconsistencies between 401(k)s and other investable assets.
Here are 6 of the most common 401(k) investment account questions, mistakes that we often see, and what strategies you can consider in your retirement planning.
One of the most common mistakes is treating 401(k) investment accounts separately from the rest of your portfolio. In thinking about their financial long-goals, new clients often do not even think about how the 401(k) accounts can help them reach these objectives and the importance of having strategic consistency. While the rest of the portfolio might be following one recommendation and risk tolerance level, the 401(k) allocations may be misaligned or even contradictory.
The 401(k) account is one of the puzzle pieces in your overall financial picture, and it should be aligned as much as possible with your overall retirement plan and investment strategy.
Why? Your financial plan should have a certain asset allocation goal. You’ve worked to establish a certain risk tolerance with your portfolio to achieve that goal, based on a number of factors. If the 401(k) is not factored into the plan and achieving that goal, your risk tolerance could be disjointed, being more risk heavy or more conservative than it needs to be. Bringing your 401(k) accounts into the mix allows you to develop a better informed asset allocation strategy.
As a starting point to align your 401(k) with your overall portfolio investment strategy, look for the 401(k) investment options that are most consistent with what’s happening in your other accounts. As a hypothetical example, depending on your risk tolerance, your other accounts may be prioritizing value over growth at a certain asset allocation, or domestic over international at a certain percentage. While the employer-offered investment options are limited on a 401(k), certain options will be more consistent with these determined strategic allocations in other parts of your portfolio. Aligning your 401(k) allocation’s risk tolerance and strategy with the rest of your portfolio is a good first step in thinking about how your account can be factored into your retirement planning.
Picture this: an individual takes on a new career path at a new company, fills out the initial 401(k) paperwork setting options and allocations, and doesn’t look again at the account for 20 years.
If this sounds like you, don’t spend too much time blaming yourself. It is one of the most common mistakes we see when bringing on new clients! The nature of how 401(k)s operate can make it easy to fall into the temptation of a “set it and forget it” mentality.
We recommend reviewing your 401(k) investment accounts on an annual basis to ensure it still aligns with your asset allocation goals. More often than not, you probably won’t end up making major changes, but you want to make sure everything is still consistent.
If you recently made a change to your investment strategy, it’s a good idea to go back into the 401(k) and look at shifting allocations as needed.
We often see individuals who are using their 401(k) contributions as their sole long-term savings strategy.
While an important part of your retirement planning and how you will withdraw funds to pay for living expenses, it is important to consider other options and diversify your savings. HSA accounts for medical expenses or 529 plans for education-related expenses can be additional useful accounts to help you achieve your goals. After all, in most cases you cannot withdraw funds from your 401(k) investment accounts before age 59 ½ without a 10% tax penalty!
When it comes to diversifying your savings, you should also think through different asset locations and tax planning. Let’s jump right into that with our next question.
In short, yes! An important part of your retirement planning should be thinking through which assets should be in your 401(k) versus other types of accounts.
It all comes down to tax planning.
Note: For an in depth look at how different types of investment accounts are taxed, check out our blog article here, “Understanding the Tax Treatment for Various Types of Investment Accounts.”
401(k) investment accounts have two main advantages from a tax planning perspective:
When considering these tax planning advantages, you might consider asset positions that have a larger growth potential. While you may have to pay a capital gains tax on assets in other taxable accounts, this will not be an issue in the 401(k). Thinking through this tax planning perspective, a more “tax friendly” stock might make more sense in a separate taxable account, and stock positions with high growth potential in the tax-deferred 401(k) account.
Roth 401(k)s might also make sense for a portion of your assets, especially if you anticipate a higher income tax bracket later on when you get ready to withdraw for retirement. Taxes for assets in a Roth 401(k) are paid right away, but the assets benefit from tax-free growth and tax-free withdrawal later on.
Diversification across asset locations and types can be crucial in thinking about your retirement withdrawal strategy. Pairing up withdrawals across a variety of different accounts, with different tax implications, can help you avoid major unexpected tax liabilities. For instance, if your 401(k) investment account has the majority of your assets and functions as the sole withdrawal account when you start retirement, you are going to end up paying high tax liabilities. In contrast, if it makes sense to pair up your 401(k) with a Roth 401(k) (tax-free upon withdrawal), you can withdraw amounts from both to match your living expenses, reducing the overall tax burden. Diversifying across your qualified retirement and investment accounts allows you more flexibility in making a strategic plan for your withdrawals.
Required minimum distributions, or RMDs, start at age 72, and should also be factored into your 401(k) retirement planning. An RMD is the amount of funds that must be pulled from certain retirement accounts (401(k), traditional IRA, SEP IRA, SIMPLE IRA) on an annual basis. This amount is based on a combination of the December 31st account value from the previous year and life expectancy value from the IRS.
For many retirees who have been saving so much for retirement, hitting 72 and being required to withdraw funds can mean the highest income they’ve had in their entire life. It is important to make a strategic tax plan for this event to offset the liabilities. Certain qualified retirement accounts, like 401(k)s and Roth 401(k)s are subject to the RMD rule, but other accounts like a Roth IRA do not.
If you partner with a financial advisor like Burney Wealth Management, they can help you build out a retirement withdrawal plan and diversify allocations to optimize your tax planning.
Many people will contribute only the percentage that the employer will match. For instance, if the employer will match 6%, the employee will stop at a 6% contribution.
As mentioned a few times in the questions above, 401(k) contributions should be planned as part of an overall financial strategy. It’s about sitting down and figuring out what you need to retire, and where to park your assets to help you achieve these goals. Depending on the answer and plan, you may need to bump up your 401(k) allocation to a higher amount on a yearly basis.
It’s also important to note: unlike a taxable account where you can contribute a large amount all at once, you have a 401(k) contribution limit for each year. You want to take advantage as much as you can year by year, and not potentially lose opportunities by choosing not to contribute as much as needed to achieve your goals.
It is not uncommon for new clients to come to us with multiple 401(k)s from past employers.
From a housekeeping perspective, trying to manage multiple 401(k) accounts, reviewing and keeping them aligned to your overall investment strategy (as explained above), and remembering all your logins and passwords can lead to stress and concern.
It is often advantageous to consolidate your 401(k) accounts by rolling into your new 401(k) account or into an IRA account, depending on your asset allocation goals and objectives. One of the advantages with an IRA account, versus your new 401(k) account, is that you have much more investment flexibility.
Moving your old 401(k)s can be a huge headache and a daunting task, especially if you have more than one. They don’t make this an easy process for individuals! From a client-service perspective, our Burney Wealth team helps clients navigate this process all the time. We will assist you in setting up the conference call with the right people from the 401(k) company, and make sure you feel confident that you are going to get the check sent to the right address. We’ll even send you a pre-stamped envelope so you can quickly send the check to the right location.
Whether it’s planning for retirement withdrawals from a tax perspective or thinking about your annual contributions, your employer-sponsored 401(k) account should be a key factor in your retirement planning.
If you haven’t already, consider offloading the complexity and burden onto our team at Burney Wealth Management. We’ll review your 401(k) statements as part of our custom financial plan, tailored to your unique situation and presented to you before becoming a client.